Investors are growing increasingly worried about a looming Greek debt default, as the country’s deepening recession means that lenders are being asked to agree to even steeper write-offs on their Greek debts.

German Chancellor Angela Merkel and French President Nicolas Sarkozy turned up the heat overnight, warning that Greece would not receive its next instalment of aid money until negotiations with private sector creditors on reducing the country’s huge debt burden were finalised.

“We must see progress in the voluntary restructuring of Greek debt,” Merkel warned at a joint press conference in Berlin. “From our point of view, the second Greek aid package including this restructuring must be in place quickly. Otherwise it will not be possible to pay out the next tranche for Greece.”

Last October, European leaders agreed to provide the embattled country with a second €130 billion ($US166 billion) bailout, but the deal partly depended on private sector creditors — such as banks, pension funds and insurance creditors — agreeing to write down the value of their loans by 50%. In addition, Greece agreed to implement tough austerity measures, cutting government spending and introducing difficult economic reforms.

Officials from the “troika” — the European Union, the European Central Bank and the International Monetary Fund — will return to Athens next week to assess the country’s progress.

But their assessment is unlikely to be favourable. The Greek economy contracted by about 6% last year, roughly double the official forecast. What’s more, the economy looks set to contract again this year, marking the fifth consecutive year of recession. At the same time, Athens has failed to live up to its promise to collect more taxes by clamping down heavily on tax evasion. And the country’s program for selling off state-owned assets has fallen badly behind schedule.

As a result, the troika has little option but to change the benchmark figures on which Greece’s second bailout is based. According to the German publication der Spiegel, an internal document produced by the troika indicates that three possibilities are being considered. The first is for Greece to adopt even tougher austerity measures. The second possibility is for private sector creditors to take even larger write-offs on their loans. The third alternative is to increase the size of the second Greek bailout.

According to der Spiegel, at this stage, the troika is hoping that private sector creditors will agree to take large write-offs on their loans. But this appears wishful thinking. The Institute of International Finance, which is representing banks and other lenders, has warned that lenders are not willing to take more than the 50% write-off agreed last October.

Negotiations have become even more complicated because Greece’s lending group itself is becoming increasingly divided. Hedge funds have been buying up Greek bonds (it’s now estimated that such funds hold about €50 billion of Greek bonds) and they have no interest in discussing larger write-offs.

Last month, a Spanish hedge fund, Vega Asset Management, threatened legal action if Greece insisted on write-downs of more than 50% of the debt.

Other bankers complain that the Greek debt restructuring is unfair because only private sector creditors are being forced to take write-downs. They argue that the only way for Greece’s debt to be reduced to a manageable level is if official lenders — European governments, the IMF and the ECB — also agree to write off part of their Greek loans. But European leaders are refusing to countenance this approach.

Meanwhile, time is running out. Greece has €17.5 billion of bonds maturing in March. Unless the country’s second bailout package is agreed by then, the country faces the risk of a disorderly default.

*This article first appeared on Business Spectator